Beyond the green: The changing face of sustainable finance
World leaders and climate change experts are expected to descend on Glasgow as part of COP26 – the 2021 UN Climate Change Conference – at the end of the year on a mission to take further steps towards cutting the rate of global warming. While the rise in popularity of funds linked to environmental, social and governance (ESG) has been significant over recent years, some commentators have been critical of the time taken to bring a sufficient variety of competitive products to market.
Even though such investments are vital in the move towards a net-zero future, it’s the area of transition finance that will arguably play the biggest role in paving the way for the transformation to a low-carbon economy encompassing all sectors globally.
“I think we all realise that the emergence of the sustainable finance market has been quite remarkable,” says Daniel Klier, Global Head of Sustainable Finance, HSBC. “If you look at the green bond market alone, for example, it’s in the $500bn range this year and last year was 4.5% of the total bond market. “Green finance is of course relevant, advisable and noticeable, but it’s also a market dominated by government and multinational development banks that are actively and purely green. If we want to achieve net zero for the global economy, we have to move this discussion into the real economy.”
In the first of a new series leading up to COP26, scheduled to take place in November, we explore the role of transition finance in the push towards a net-zero future – and examine why funding green business is only part of the picture.
Investing in change
HSBC is one of many banks noticing a significant demand among its client base for supporting their transition to a greener, more sustainable business model. In late 2020, the bank announced its commitment to injecting between $750bn and $1tn of finance and investment into clients’ transition projects by 2030.
In the past year, the bank has supported a variety of clients on their transition journey, including Volkswagen, Chanel, Burberry, Etihad Airways and building materials company LafargeHolcim. “If you take cement, which is one of the most intense emitters of CO2, it’s not immediately obvious what the transition journey would be,” says Klier. “It’s really encouraging that building material industries have set out a strategy to reduce emissions, and are saying, ‘we need to find frameworks and incentivise the company to make the right investments and create transparency with investors’.
“The events of 2020 made it so clear for every investor that ESG is much more than a marketing phrase. It became very obvious that companies with a better ESG profile, particularly companies with a stronger alignment to climate themes, significantly outperformed the market.”
According to 2020 research from HSBC, companies with a better ESG score outperformed the market average by 4.5%, while companies aligned to climate solutions outperformed the market by 14%. “I think companies have realised that if they don’t use the crisis to fundamentally change the business model towards technology-enabled, climate-aligned business models, their valuations will go nowhere.”
A wider impact
While the focus of transition finance remains on the goal of reducing emissions, policymakers say it’s also vital that supporting the transition to net zero is globally inclusive. “We talk about the just transition,” says Bella Landymore, Policy Director, Impact Investing. “It’s about ensuring that, in the transition to a net-zero economy, we’re not leaving behind or disadvantaging communities, and we’re optimising the opportunities that come from that transition for societies.
Projects must be able to build back better, and contribute towards the regrowth of economies and communities. Transition finance is integral to this.” Moving away from carbon-intensive industries, Landymore explains, has the potential to put a significant number of jobs and communities at risk, which must be counter-balanced with the opportunities created through the introduction of new, replacement industries and technologies. “
Projects must be able to build back better and contribute towards the regrowth of economies and communities. Transition finance is integral to this. It’s everything that will make that transition possible. It’s about investments that will actively seek to mitigate negative impacts of the transition to net zero and optimise the opportunities of positive impact via net zero. This concept is really championed by multilaterals such as the Organisation for Economic Co-operation and Development [OECD], the EU and the UN. It’s increasingly gaining ground due to the impact of COVID-19 and the clear link between economic, environmental and social disaster.”
Rising demand
The social and environmental necessity for sustainable business models has been well documented, but the implications of a global pandemic seem to have heightened demand for transition finance that supports businesses at all stages of the journey.
“As we start to emerge out of COVID-19, many of our clients are realising that a positive vision for the future strategy of their business is incredibly important,” says Klier. “This is a discussion around ‘how do I paint a picture of 10 years or 20 years from now that investors and previous customers believe in?’” He draws on the example of Tesla, the electric car manufacturer valued at more than $500bn in November 2020. “That makes boardrooms think about how they reposition their company to get that level of valuation and, therefore, excitement across the industry.
The second reason this is now so interesting for our clients is they need to be able to better demonstrate to their investors that they understand what is required from them. And the transition finance instrument is really helpful because you can start to put KPIs [key performance indicators] out there, often pegging your interest rate to certain deliverables. It builds trust that this is more than just marketing and is embedded in the way you run the company.”
Shades of green
What may have started as investment in already green, environmentally conscious companies is now experiencing a major shift. Klier believes that one of the main problems with the idea of green or sustainable finance is that it’s becoming increasingly difficult to define, and risks cutting off the sectors that may need the most support.
“It’s not clear cut what is actually aligned with net zero and what isn’t,” he says. “This is why the discussion about transition is so critical. It’s the only way to achieve what we have to achieve together. “The broadest sort of sustainability linked loans and ESG-aligned bond frameworks are really critical because they incentivise companies to invest in the right areas and also create much more transparency in where individual companies stand on this transition journey.”
The sustainability framework
The next step for transition finance – and sustainable finance more widely – must focus on measurement and management. “Impact measurement and management is one of the biggest hindrances to the growth of the sustainable finance market,” says Landymore.
“When we talk about investment vehicles that have environmental and social benefits, what do we really mean? Our work involves digging into and advancing that conversation. What are the social benefits? How do you measure them? What frameworks exist? How does it link to the work that’s been done by the hundreds of other initiatives out there?”
Front and centre
With work still to be done to iron out the regulatory creases – and to educate and inform bankers to support clients at all stages of transition – there are many reasons to be optimistic as we approach COP26. The Network for Greening the Financial System (NGFS) includes, among its 83 banks and financial institutions, the Bank of England.
Klier believes the network’s climate regulations and stress-test tools put the topic front and centre in the boardrooms of every financial institution. “I think 2021 will see an acceleration in this area because we have COP26 coming up, the US back at the table and China signalling very positively that it is aligning itself to a carbon-neutral target by 2060,” he says. “The UK has an incredibly important role to play by essentially showing that climate diplomacy can still work. I’m quite optimistic that this has moved from the risk return into the financially relevant space and is now much more than just a good story.”
A clear vision
For Landymore, the priorities lie in attracting significant private capital to the ESG and transition finance space – and identifying the instruments that can achieve this. “There have been a number of recent financial innovations which demonstrate public and private sector appetite, including so-called ‘blended-finance’ vehicles, which might combine philanthropic with institutional investment, as well as use other mechanisms such as guarantees or risk insurance,” she says.
“But just transition and transition finance are very big categories and we have to dig deeper into what that really means. This includes sectors like sustainable agriculture and green energy, as well as a raft of others. The priority is in identifying which sectors have the most opportunity or which sectors need the most attention. This includes which investors are interested in the sectors or which or can be combined together to make the greatest impact.”